Future Focus: The biggest detractor of wealth creation
There’s nothing we can do to stop the impact of inflation, but we can offset it. Use our free calculator to offset it with accuracy.
Inflation is front of mind for Australians. Price increases since COVID have led to a cost-of-living crisis and a lower quality of life. Over the longer term, inflation is often described as the silent killer of wealth. Not only is it causing pain now, but it is also impacting longer term financial goals and the ability of people to maintain their purchasing power.
In an article where I itemised the detractors from an investor’s total returns, inflation came out in front as the biggest impact over the long-term.
Although most people understand how inflation works, it is important to understand the true impact of inflation on your quality of life. A Vanguard study on the impact of fees on super outcomes provided an impetus for the time-consuming process of switching super funds.
In the same way, my goal is that illustrating the impacts of inflation will get investors and potential investors to understand how important it is to combat inflation over the long-term. Too many people are doubly squeezed by increasing cost of living, and low wage growth.
This article is part of a two-part series. This edition focuses on the detrimental impact of inflation, with the edition to follow concentrating on how to invest on a modest income to combat inflation.
The impact on your purchasing power
In simple terms, inflation means a dollar today is worth more than a dollar tomorrow. The money in your transaction account in your bank, earning a measly interest rate is likely depreciating in value.
Inflation acts as a hurdle rate that must be earned on your money to ensure that it maintains its purchasing power. If your interest rate or investment earnings are below this hurdle rate, you can purchase less in the future with your savings.
Many Aussies choose to use the headline rate of inflation, but it’s important that you’re taking your own circumstances into account as the impact can drastically differ depending on your lifestyle and spending habits. More on your personal inflation rate later.
Combating inflation isn’t just about beating this hurdle rate. There are other factors out of your control that cause inflation to creep into many facets of your life.
It is particularly toxic when combined with low wage growth. Wage growth has languished in recent years. It has meant that a larger portion of wages are directed towards necessities, causing Australians to have less for discretionary spending and investing.
What burning the candle at both ends looks like
Over the past few years, the consumer price index (“CPI”) has meaningfully outpaced wage growth. This is why many of us have felt the dual pressures of CPI impacting the purchasing power of savings and eating away at salaries.
Combating inflation by investing
Most employees in the private sector are unable to demand annual wage increases that match inflation. For contractors and self-employed individuals, wages are dependent on the growth and success of their business. As a result, any savings need to work particularly hard. This means not just earning a return that matches inflation but instead trying to exceed it. Achieve inflation beating returns can help bridge the gap between wage growth and inflation.
Here are a few points to think about:
- Ensure you have an emergency fund and maximise the interest rate you get. Be proactive about finding the best rate for your funds, especially if it is a large amount of savings.
- Consider investment vehicles that allow you to invest small additional contributions without having to incur transaction fees each time. The investment products you choose should be dependent on the amount you have to invest. When I was on a lower income, I used managed funds to invest. Depending on your circumstances, you may be able to use ETFs or shares.
Investing to maintain your purchasing power will make a difference. Let’s take a look at an example over a longer time horizon. I have $1,000, and I’m able to save $100 a week with 2.5% inflation.
*The inputs used for investment return are the CBA Smart Access transaction account rate at 27 March 2025, the average savings account rate over the last 10 years (MoneySmart) and Morningstar Investment Management’s future projected returns for Australian shares, respectively.
- Understand your spending habits and don’t base your inflation hurdle rate on the average punter. Work out your personal inflation rate to ensure that you are accounting for your own circumstances.
Your personal inflation rate
In the past 20 years, Australia’s inflation rate has mainly stayed between 1.5-4.5 per cent per annum, with the majority of the years falling between 2-3 per cent. The official inflation rate is based on an ‘ordinary’ household. Your personal inflation rate takes into consideration your individual circumstances and where you spend your money. This indicator gives you a better understanding of the rate your money needs to grow to ensure your purchasing power is increasing in real terms.
Since we all spend our money on different products and services in different regions, it’s useful to personalise inflation. The ‘ordinary’ Australian in the CPI calculation divides spending in the following way in 2024.
A personal inflation rate is the proper benchmark to aim for to maintain purchasing power. It can also inform your investment strategy and is a key input into financial planning.
1. Your interest rate on cash
If your personal inflation rate is higher than the interest rate that you are receiving in your bank account your purchasing power is decreasing.
There are many legitimate reasons why cash may be kept in bank accounts. Two examples are an emergency fund or a deliberate allocation as part of a retirement strategy. If you are holding cash unnecessarily it means it will be harder to earn a return that exceeds inflation. My suggestion is to focus on risk capacity instead of risk tolerance when deciding on asset allocation. This will better align asset allocation with your goal instead of reflexively holding defensive assets.
2. Your investment projections and portfolio planning
Inflation is a key input into your portfolio construction process. It contextualises growth in your portfolio by focusing on what you can buy in the future instead of an arbitrary dollar figure. Using a generic inflation rate means that you may be under or overestimating the amount you need to achieve your goal.
For example, my personal inflation rate is at 2.95%. This is mainly due to my spending in food and alcohol which have a higher inflation rate than the headline 2.4%. I also spend meaningfully less on transport, which has a negative rate.
I ran a scenario in Morningstar’s Portfolio Projection tool. If I had $100,000 and contributed $1,000 monthly over 20 years, earning a return of 6% p.a, these would be my results.
The difference between the future value of the portfolio and the value in today’s dollars is stark.
What’s your personal inflation rate?
You can calculate your own personal inflation rate (December 2024 figures) using our spreadsheet and by following the steps below.
1. Click here to download the spreadsheet and save a copy on your computer.
2. In the “Amount spent over the year” column input the amounts that you spent on each category. If you’re not sure how much you spent over the year, the Moneysmart Budget Planner is an excellent tool. It is comprehensive and accounts for one off expenditure that may occur annually (e.g. rates, car rego) that a quarterly budget may not catch. This means it is more representative of your spending.
3. The spreadsheet will automatically calculate your personal rate of inflation for each category (Column G) and your overall personal rate inflation (Cell G20).
Review
CPI and inflation numbers are released every quarter. This does not mean that you must review your personal inflation rate every quarter and change the trajectory of your investment plan. As part of your annual or semi-annual portfolio review take a look at your personal inflation rate.
Carefully consider one off expenses – you may not be going on a $20,000 European holiday every year. It is unlikely you are purchasing a $30,000 car every year. This will impact your personal inflation rate and it may be worth omitting these expenses for future planning.
For investors who are using this calculation as an input to estimating the cost of long-term goals it is worth considering the drivers of a drastic change in your personal inflation rate. Whether it is one-off expenses or abnormal economic environments that will not continue over the long-term.
Over time, inflation tends to smooth out and fall within a 2-3% band in Australia. It is likely that your personal inflation rate will have a similar band that you are able to use as guidance. It is not likely that you will have large jumps or falls often but be informed about whether it is worth changing the goalposts.
Final thoughts
Inflation is unavoidable and impacts our short-term spending and our long-term wealth creation. Ensuring that your wealth maintains its real value over time is critical. It can also be a mechanism to offset slow wage growth.
Investing with inflation in mind is not just about keeping up, it’s also about getting and staying ahead.
